An exchange traded fund (ETF) is a collection of securities, which can be traded on the stock market. ETFs share similar characteristics with mutual funds, but unlike mutual funds, you can trade an ETF on the stock market whenever you choose with live intraday prices, like equity shares. Therefore, ETF combines the features of stocks and mutual funds to offer you the best of both worlds. In this article, we dive deep into what an ETF is and how to invest in an ETF.
This article covers:
- What are exchange traded funds?
- Investment strategies to follow for ETF
- Types of ETFs
- Advantages of an ETF
- Limitations of an ETF
What are exchange traded funds?
ETFs evolved from mutual funds and were introduced in the early 1990s. They combine the diversification advantage of mutual funds with the liquidity benefit of stocks. ETFs also are pooled investments that combine the financial resources of investors and use them to buy other tradable instruments such as shares, bonds and derivatives.
An ETF is like a fund that can consist of various stocks across different industries, or it can be focused on a particular industry or sector. For example, an automobile-based ETF will consist of stocks of different automobile companies listed on the stock market.
Changes in the price of an ETF are directly related to the performance of the underlying asset it consists of. If the value of an underlying stock increases, so will the price of an ETF and vice versa.
Investment strategies to follow for ETF
There are different types of strategies you can follow when investing in an ETF. One of the more popular approaches is a passive strategy which involves following a systematic rules-based approach to selecting the underlying stocks. These passive ETFs mirror an existing index like the Nifty 50 or follow a rules-based approach that is predefined.The performance of the underlying asset in which an ETF invests is directly tied to changes in the price of the ETF. When the value of an underlying stock rises, the price of an ETF rises as well, and vice versa. Click To Tweet
With this type of strategy, there are two options. The first is that the index could be entirely replicated by buying all the stocks that make it up. The other option is buying securities of the index that shows the most representative sample based on the exposure and risk.
An active strategy on the other hand involves an individual or team selecting stocks depending on their perception of the market conditions and future predictions. Often, an investment manager actively manages a portfolio of various securities. After completing thorough research on stocks, the weights are allocated to these stocks on the basis of the valuation and industry trends.
Types of ETFs
There are various types of ETFs available to investors. Some of the most popular ones include the following.
These ETFs consist of listed company shares and track indices such as Nifty 50, Nifty 100, and Sensex.
These ETFs consist of companies, which trade in fixed return securities such as government bonds and debentures.
These ETFs comprise commodities such as gold and other metals. Commodity ETFs make it possible for you to own a particular commodity such as gold, for example, without having to actually purchase it physically and find a place to store and deal with the associated hassles of security.
These ETFs are instruments that track the performance of currency pairs which include domestic as well as foreign currency. Currency ETFs mainly profit because of currency fluctuations and depend a lot on economic as well as political factors.
Advantages of an ETF
- Liquidity: ETFs offer instant liquidity and can be traded anytime during market trading hours. Comparatively, mutual funds which share similar characteristics to ETFs cannot be traded instantly and only the price at the end of the day can be applied as sale price.
- Diversified portfolio: ETFs allow you to spread your wealth over a diversified portfolio of industries, thus minimizing your risk compared with investing in a stock of a single company. Even if a particular asset underperforms, it may not impact the overall value of the ETF as another asset in the same pool might have done well.
- Transparency: ETFs are very transparent as holdings are published on a daily basis.
- Lower expense ratios: When compared with mutual funds, ETFs have a lower expense ratio, being passive investments. Another major advantage with ETFs is that there are no penalties if you exit.
Limitations of an ETF
- Tracking error: ETFs that track an index have a common error called the tracking error. This happens when there is a difference between the index return and the fund return. The fund manager is tasked with keeping this minimal.
- Volatility: ETFs listed on the stock market are subjected to market price fluctuations. There is an element of risk associated with them.
- Availability: There aren’t too many ETFs available as of today which invest in a diversified portfolio. Most current ETFs are limited to largecap, midcap, gold and debt.
ETFs have been gaining popularity in the recent past because of the flexibility they offer. They build on the advantages of mutual funds by offering higher liquidity and a more efficient structure that has many benefits for investors.
For young investors who are just starting to invest in the stock markets, for example, ETFs are a great option as they mirror the index performance while not exposing an investor to a single stock of a company. They also offer flexibility in terms of the stocks universe you want to include in your fund (largecap, midcap, and smallcap), or if you are not sure, offer a more traditional passive approach, which follows systematic rules.